There was some scepticism whether the Masala bond market would take off, but in a very short period of time it has become flavour of the month with both issuers and buyers.

For lovers of Indian food, the term “masala” is evocative. It is a warm word that brings to mind the aromatic spice blend of peppercorns, cloves, cinnamon, nutmeg and mace, among others, that are the basis for one of the world’s great cuisines. It was a no-brainer therefore, in 2014, for the International Finance Corporation, the investment arm of the World Bank, when it was looking for a name for rupee-denominated bonds issued to offshore buyers to call them “Masala bonds”.

Although the market is still at a nascent stage, in the last quarter the bonds have left the drawing board and become real. Thanks to enthusiastic backing from prime minister Narendra Modi, who believes that issuance will boost India’s economic growth, the regulations were only established in fourth quarter of last year. This was when the Reserve Bank of India (RBI), the country’s central bank, issued guidelines that allowed Indian corporates, non-bank financial corporations, real estate investment trusts and infrastructure investment trusts to issue Masala bonds.

It is a sign of the waves that they have made that the regulations were tweaked again at the end of August. As well as allowing issuance of longer tenor transactions, the RBI ruled that Masala bonds can count towards Tier 1 and Tier 2 capital.

“It is extremely encouraging that the RBI is acknowledging the potential of the Masala bond market. We expect the RBI’s move will help banks to manage their balance sheets better and lower their funding costs. Overall, it should have a positive impact on local interest rates,” said Terence Chia, head of debt syndicate in fixed income Asia-Pacific at Credit Suisse.

Almost immediately, the country’s largest bank, State Bank of India, said that it was planning to test the water with an AT1 issue, though, at the time of writing, details are still being finalised.

Back to the beginning

But to go back to the beginning: after a considerable amount of jaw-jaw for the first half of the year, the first issuer to come to market was top private sector mortgage lender Housing Development Finance Corp. In mid-July, it sold Rs30bn (US$448m) of three-year and one-month offshore rupee bonds via Axis Bank, Credit Suisse and Nomura. Not only was the deal heavily oversubscribed, it priced flat to HDFC’s domestic curve.

In terms of what it was trying to achieve, the bond was an out-and-out success. “The bond pricing was surprisingly competitive relative to onshore funding considering uncertainty over liquidity and currency risks,” said Saswata Guha, director of financial institutions at Fitch Ratings.

This was followed very quickly, in early August, by NTPC, India’s largest Indian power company. It priced Rs20bn five-year paper at 7.48%. Upsized, the paper priced at the tight end of guidance, inside NTPC’s onshore curve and an eye-popping 20bp inside the Reuters AAA five-year benchmark for Indian government bonds. It is worth mentioning that demand was clearly helped by the paper’s green label, which allowed the leads to attract dedicated Green bond funds from Germany and Denmark.

It is hard to think of a better opening to the market. As Jujhar Singh, head of capital markets, South Asia, at Standard Chartered (and lead on the deal along with Axis Bank, HSBC, and MUFG) put it: “The trendline from the first two transactions, in terms of tenor, number of investors and investor mix, shows the start of a good curve”. It shows that investors are clearly starting to take a longer term view on the product.

While these are the only two deals that purists acknowledge as proper Masala bonds, there have been a couple of other issues that are closely enough related to point to enthusiasm for the product. In early August, Adani Transmission, the transmission business arm of Indian business conglomerate Adani Group, sold Rs5bn five-year Masala bonds at 9.10% via Credit Suisse and into the private market. The same week, the Asian Development Bank priced a Masala bond of the same size and tenor at 6.45% via Citigroup and JP Morgan.

The reason why issuers have taken to the market is straightforward: it is to diversify funding. While an attraction is clearly the liquidity of the international markets, it is the new investor base that is the draw.

“We were keen to tap a new investor base for our renewable energy programme and avail ourselves of offshore financing without the associated exchange risks, both objectives we could achieve with this offering,” said Kulamani Biswal, director of finance at NTPC.

The attraction for the buyers is slightly more nuanced, though there is no doubt not only that it is there but that it is growing. It is notable that while the HDFC issue attracted a respectable 40 investors, NTPC brought in a distinctly impressive 60.

First and foremost, as Credit Suisse’s Chia explained, “it is a rates and FX play”. Certainly, the books have been dominated by rates players who look at the interest rate curve, rather than straight credit buyers. But it is not quite as simple as that. It is clear there is interest from those that want exposure to the Indian economy – “the strength of the Indian economy has led to increasing demand from international investors for Indian rupee-linked bonds,” said ADB treasurer Pierre van Peteghem – but investors want access with little risk.

The Masala product is geared towards those who like very blue-chip products or the sovereign, explained Alka Anbarasu, senior analyst at Moody’s in Singapore. It is no accident that the two issues to date are Triple A rated.

“The Indian rupee has depreciated by about 5.3% on a year-on-year basis, allaying some investor concerns about emerging market currency risk at a time when financing conditions have become less favourable for many developing countries,” she said.

Taxing issue

Rather prosaically, there is also the issue of tax. Masala bonds are attractive at the moment because while onshore rupee investors have to pay a 5% withholding tax, for those who buy offshore, the tax cost is swallowed by the issuer. Even though changes to this are hoped for further down the line, pragmatically bankers suggest that it is a price that issuers will be prepared to pay. “The cost of issuance is more expensive for them … but it does diversify their funding,” said one DCM banker with a shrug.

Much has been written about the lack of liquidity in the Masala bond market. But these cavils should not be taken too seriously. The Masala bonds that have emerged so far have been aimed at the “buy and hold” market, with predominantly real money accounts participating. “You don’t see a lot of flippers in this market. If that is what you want to do, this might not be the product for you,” said Credit Suisse’s Chia.

Despite the lack of momentum-based investors, nonetheless, by late August, there were signs of a real secondary market. One regional head of DCM said that there were four players making markets in Masala bonds on the morning he talked to IFR. “In secondary, the demand far outweighs supply,” he added.

Unsurprisingly at this early stage, few are prepared to prepared to put a figure on where they see the size of the market by the year-end. It is unlikely to hit the size of Panda bond issuance, which so far this year stands at US$15bn, according to figures from Reuters, but some say that it could be as much US$5bn within the next few years.

So, what is needed for the market to get there? Standard Chartered’s Singh is very clear about this. “We would like to see investors move down the credit curve, from locally AAA rated issuers to AA+ and AA rated” he said.

He is adamant there has to be a move away from governmental or quasi-governmental issuers. “Once that happens, then you will start to see multiple issuers”.

Fitch’s Guha agreed. “The next test will be for issuers further down the credit curve to try tapping into this market,” he said.

It remains early days, but all of the names being bandied around at the moment show what could turn into a significant pipeline. Indian Renewable Energy Development Agency (IREDA) is looking to ape NTPC and could raise as much as US$250m from Green Masala bonds, while National Highways Authority of India, Dewan Housing Finance and Power Finance Corporation are all mulling plans at the time of writing. Even Adani Ports, a sister company of Adani Transmission, is looking at a possible issue.

But perhaps the biggest sign of faith comes from HDFC, which wants to return to the sector and is said to be planning an issue of at least Rs20bn. If these plans all come to fruition, then the Masala bond market will be well and truly open.